Entrepreneurs often choose to form a limited liability company (LLC) when starting a business. While LLCs are often structured with many corporate characteristics, most entrepreneurs elect to have LLCs taxed as partnerships to take advantage of certain benefits (like "pass through" tax treatment and the personal use of losses). This combination of entity characteristics, while seamless and harmonious in most places, creates unique challenges in the area of equity compensation. LLCs often want to grant equity interests to key employees or service providers to motivate and reward them to grow the business. While the traditional corporate equity compensation method of incentive stock options is not available to an LLC, there are several avenues through which it may provide incentive compensation.
The basic forms of equity compensation an LLC will typically consider include a profits interest, a capital interest and an option to acquire a capital interest. A profits interest is an interest in the future profits and appreciation of an LLC, but is not an interest in any liquidating proceeds that would be distributed at the time the interest was granted. By contrast, a capital interest represents ownership in both the LLC’s future profits and its current and future capital (i.e., net assets) upon liquidation. An LLC may also grant an option to acquire a capital interest.
Capital interests are substantively similar to stock in a corporation. Options for capital interests are fundamentally similar to options for stock in a corporation (of the "nonqualified," not the "incentive," variety). A profits interest does not have a corporate analogue. Consequently, the remainder of this article focuses on profits interests, because they can be very beneficial but may be less familiar than other forms of equity compensation. In addition, the tax consequences of profits interests require careful consideration.
One of the benefits of a profits interest is that it may be structured similarly to a stock option but may be more attractive to the recipient because a profits interest grant, in some cases (at least under current law) can provide that all appreciation in value be taxed as long-term capital gains rather than ordinary income. Furthermore, unlike a stock option, the recipient does not have to pay to exercise the options to receive such favorable tax treatment. In addition, a profits interest allows the LLC to make the recipient a member of the LLC with rights equal to those of the other members with respect to future profits and future growth in the LLC, while allowing the original members to retain full right to the value of the LLC prior to the grant of the profits interest.
While the current federal tax treatment of profits interests is relatively clear, there are potential regulatory and legislative developments that might result in significant changes. As a result, tax treatment of profits interests requires careful consideration. A profits interest may be granted as a fully vested interest, or it may be unvested and subject to substantial risk of forfeiture based on continued service or the achievement of performance goals. A profits interest is considered vested if it is not subject to a substantial risk of forfeiture or is freely transferable. A profits interest is unvested if it is subject to a substantial risk of forfeiture because the recipient’s right to the profits interest is conditioned on the future performance of services.
Vested Profits Interests
Based on current law, a vested profits interest may or may not be taxable depending on whether the safe harbor in Rev. Proc. 93-27 applies. Under Rev. Proc. 93-27, the IRS states that it would not treat the receipt of a profits interest in exchange for past or future services as a taxable event for the recipient or the LLC if the following conditions are met:
- The recipient must receive the profits interest in his or her capacity as a member, or in anticipation of becoming a member, in exchange for the provision of services to or for the benefit of the LLC granting the interest.
- The interest must not relate to a substantially certain and predictable stream of income from LLC assets, such as income from high-quality debt securities or a high-quality net lease.
- The recipient must not dispose of the profits interest within two years of receipt.
- The profits interest must not be a limited partnership interest in a "publicly traded partnership" within the meaning of IRC 7704(b).
Unvested Profits Interests
While Rev. Proc. 93-27 clarified the tax treatment of a vested profits interest, the treatment of an unvested profits interest was unclear. Rev. Proc. 2001-43 provided that clarity and simplified the process of providing unvested profits interests to a service provider of a partnership or an LLC. Rev. Proc. 2001-43 provides that neither the granting of the profits interest nor the vesting of the profits interest will be treated as a taxable event. Essentially the grant of the profits interest is a tax realization event; however, the profits interest has no value, and therefore it does not give rise to any income to the recipient or to any deduction to the LLC. In order for the recipient to be treated as receiving the interest on the date of its grant under Rev. Proc. 2001-43, the following conditions must be satisfied:
- Both the LLC and the profits interest recipient must treat the recipient as a "real" member for tax purposes with respect to the entire profits interest granted beginning on the date of grant (meaning, among other things, that the LLC must provide the recipient with a Form K-1, and the recipient must pay his or her share of the taxes on the LLC’s income).
- Neither the LLC nor the recipient may take any compensation deduction in connection with the profits interest.
- All of the requirements of Rev. Proc. 93-27 must be satisfied.
Rev. Proc. 2001-43 also specifically states that under these circumstances, no IRC Section 83(b) election need be made. In effect, the LLC and the recipient are treated as if an 83(b) election was made by the recipient and assessed the fair market value of the profits interest at zero. Rev. Proc. 2001-43 requires that the recipient and the LLC use consistent tax treatment allocating the LLC’s gains and losses from the date of grant. Despite this protection, it is still advisable to file an 83(b) election upon receipt of a profits interest. If any of the requirements of Rev. Proc. 93-27 are not satisfied (i.e., there is a disposition of the interest within two years), the protections of Rev. Proc. 2001-43 are lost and the recipient would not receive the tax treatment described above unless he or she timely filed an 83(b) election. Any downside to filing an 83(b) election is generally considered minimal.
Proposed Regulations & Notice 2005-43
In 2005, the IRS issued Notice 2005-43, along with proposed regulations, which would provide additional guidance regarding the tax treatment of partnership (or LLC) interests issued as equity compensation. The proposed regulations would generally allow taxpayers to achieve the same results as are permitted under Rev. Procs. 93-27 and 2001-43, but would make important changes, including effectively requiring Section 83(b) elections to be made for unvested profits interests. Upon the finalization of the proposed revenue procedure found in Notice 2005-43, Rev. Procs. 93-27 and 2001-43 will become obsolete. Until that occurs, taxpayers may not rely on the safe harbor set forth in the proposed revenue procedure in Notice 2005-43, but may continue to rely upon current law, including Rev. Procs. 93-27 and 2001-43. The IRS has put this guidance on hold as it waits to see if there are any legislative developments in this area.
There have been a number of legislative proposals in recent years dealing with so-called "carried interest." Some version of this legislation may resurface as the president and Congress attempt to address the "fiscal cliff" and potential tax reform, and, if so, the tax treatment of some or all profits interests might be fundamentally altered, including changes in the character of related income to ordinary, from capital gain.